Why Banks are “Special”: The Short Story

No, not that kind of “special.” Though it sure is tempting…

Paul KrugmanScott Sumner (seemingly unlikely bedfellows, but…), and most other mainstream economists want to argue that banks are not special — that there’s no reason for economists to understand and analyze their operations in detail, or incorporate those understandings in their (mental and formal) economic models.

Their essential position is that borrowers’ and lenders’ incentives and reaction functions are symmetrical, interacting opposites. (This is the very essence of the Krugman/Eggertsson 2010 patient/impatient-agents paper.)

Either:

1. Banks are transparent intermediaries between real-sector lenders (“savers”) and borrowers.

Or:

2. The machinery of market portfolio allocation (i.e. as described by Tobin) allows us to model the economy as if #1 were true. cf. Krugman/Eggertsson.

So, in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can ignore the banks.

Steve, Cullen Roche, Scott Fullwiler, and many others suggest otherwise (and at length) — that banks are special and that it is necessary to model that specialness.

I’d like to explain, in brief, why they are special:

Banks aren’t optimizing intertemporal consumption preferences. Unlike real-sector actors, when banks lend they’re not “saving.” The incentives and reaction functions of the economy’s dominant lenders are completely orthogonal to those of the economy’s borrowers.

Now you could argue (back to #2, above) that the inexorable forces of the financial markets force banks (at least in aggregate) to act as if they were optimizing intertemporal consumption preferences (for their borrowers? their shareholders? their lending officers? their directors? their creditors? their depositors?). But I think many will agree that that argument is quite a stretch.

If economics, as I have suggested, is ultimately the study of human (individual and group) reaction functions, it seems irresponsible and misguided to ignore the incentives and reaction functions of some of the most powerful and influential actors in the economy, simply brushing them under the rug.

Mainstream theory tells us we don’t need to understand how banks work. To understand why that theory is wrong, you need understand how banks work.

Cross-posted at Asymptosis.

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